Capital Allocation by Another Name - Investing for Rights Issues
Richard Court, Portfolio Manager and Analyst
19 May 2015
'I don't want to belong to any club that will accept me as a member'
'A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not concerned about loss.'
RECM views any potential investment in the shares of a listed company as fractional ownership of an asset that generates cash flows. The present value of these cash flows determines our estimation of the intrinsic value of the business as a whole. This manner of thinking informs our investment team on how to assess capital allocation decisions made by the management teams of businesses. Rights issues are a specific form of capital allocation and a few have made headlines in the financial press lately.
A rights issue enables a company to raise capital from existing shareholders through a mechanism where each existing shareholder is awarded a right to acquire additional shares in the company in a set ratio to their existing shareholding and at a set price. The shareholder can choose to exercise that right, let the right lapse or sell that right to another investor. Rights issues are decisions that are put forward by the board of directors and require shareholder approval. When executed, they're effectively an exchange of intrinsic value for cash from existing shareholders.
Capital is raised for different reasons
Rights issues can broadly be separated into two distinct camps. The first camp contains businesses that raise capital in order to grow or expand a healthy business. These rights issues tend to be popular with the market as the capital raised is used to fund growth. Recent rights issues by Invicta and Discovery fall into this camp. Both of these businesses were raising capital to pursue specific growth opportunities.
The second camp consists of companies that use rights issues to recapitalise the business because the business is in distress. When a business runs into trouble and debt providers refuse to continue funding, the business is forced to knock on the door of its shareholders, cap in hand, as the capital providers of last resort. This often arises when companies have excessive debt levels. When cash flows come under pressure or companies make losses, debt covenants get breached and a rights issue become necessary for the company to continue as a going concern.
Rights issues can impact the intrinsic value of the business
Capital allocation decisions have a direct impact on the intrinsic value of a business. Value is created when less value is given up in exchange for receiving something of greater value. Investors can create value by consistently acquiring assets at discounts to the intrinsic value of those assets. Businesses create value in exactly the same manner when acquiring assets or other businesses.
The opposite holds true when you sell an asset at a premium which generates value for the seller of the asset. Rights issues are instances of companies exchanging a fraction of the business for a cash injection from existing shareholders.
Existing shareholders have a decision to make as to whether to follow their rights or not and the correct decision might not be that obvious. The simple and popular way to assess which action to take in a potential rights issue is for investors to compare the price at which the new shares are issued to the ruling share price. At RECM, we consider the price of the rights relative to the intrinsic value of the company – after the new shares have been issued. Companies that raise capital through rights issues at prices that are at a premium to their intrinsic value will create further intrinsic value per share and conversely, rights issues at prices well below intrinsic value, will reduce the intrinsic value per share.
It's the value in hand that counts
When participating in a rights issue at a premium to intrinsic value, existing shareholders only benefit from this value creation if they don't follow their rights. Not following their rights results in the overall percentage holding of an existing shareholder being diluted during a rights issue. But the end result is that the shareholder holds a smaller percentage of the company with a greater intrinsic value after the rights issue. The value of this is greater in the pocket – or the share account for that matter! – of the shareholder than would be the case had the shareholder followed their rights and allocated further capital to the company at a premium to the intrinsic value.
While management might be destroying per share value through a discounted rights issue, shareholders are able to offset some of this value destruction by following their rights and acquiring additional shares in the business at a discount. Shareholders that follow their rights will maintain their percentage ownership of a less valuable company, but they'll have greater value in their pocket compared to the shareholder who didn't follow their rights because the additional shares were bought at a discount.
We factor in a margin of safety – even when considering rights issues
Regular readers of the REVIEW will by now be familiar with our view that it's the price you pay that generates investment returns. As value investors, we rarely find ourselves involved in rights issues where shares in the investee company trade at levels that are above the intrinsic value.
Assets mostly get mispriced on the downside when there are concerns around the business. It's into this uncomfortable environment that RECM regularly steps looking for bargains – when times are tough, friends are few. The holders of the equity in a business become the last providers of capital when providers of other forms of capital shy away from the business. It's critical to have a clear framework in which to assess these opportunities.
A rights issue at a discount to intrinsic value destroys value and shareholders can only limit this value destruction by following their rights. The discount between the price of the rights issue and the intrinsic value per share after the rights issue, is what we would consider as the margin of safety.
RECM's focus on investing with a margin of safety means that we build in any likelihood of a recapitalisation into the estimate of the intrinsic value of a business before we commit any capital to an idea in the first instance. The buying decision is made only if the margin of safety is still sufficient after compensating for the negative impact of any potential rights issue. This is by no means a perfect science. Little is certain when it comes to matters of the future, but we consistently apply conservative assumptions and a margin of safety to add further protection against analytical errors.
It's important to determine whether the challenges the business faces have led to a permanent impairment to the future cash flows that underlie intrinsic value. If this is the case, and a further capital injection won't lead to a better outcome, then we'd be pouring good money after bad. This is something we hold very much front of mind when we're faced with a rights issue.
Some real life examples
Despite our best efforts, we don't get all of the decisions around rights issues correct all the time. Like every other investment decision, the best way to deal with this is to consider a number of opportunities and to have the appropriate position sizing in our portfolios. It's instructive to look at some real life examples from the RECM portfolios.
The most recent and emotive example – ABIL – still lingers. RECM started to take interest in African Bank when the unsecured lending market started to turn in 2013, the company reported a deterioration in their loan book and the market sold off the share drastically. We deliberately accumulated a small position in our funds in ABIL shortly before the rights issue in November 2013 – specifically factoring in a recapitalisation through a rights issue into our valuation of African Bank. With hindsight, our estimate of the quantum of the rights issue wasn't sufficient. The more grievous mistake though, was underestimating the impairment to the business caused by the huge amount of poor quality loans extended during the upturn in the cycle from 2007 to 2012.
There have been better outcomes in our portfolios. JD Group is a furniture retailer that also provided unsecured loans to its customers for big ticket furniture purchases. In June 2014 JD Group announced that it intended to raise R1 billion through a discounted rights issue. The capital raised through the rights issue would be used to redeem the outstanding convertible debentures and to strengthen JD Group's balance sheet. The rights issue price was set at R25 per share at a ratio of 1 new share per each 17.4 JD Group share held by a shareholder. The rights issue price was below our estimate of intrinsic value and offered RECM a chance to allocate further capital to this investment at a discount to the estimate of intrinsic value post the impact of the rights issue. At the time of writing, JD Group is the subject of an offer from its controlling shareholder, Steinhoff, to acquire all outstanding shares at a price of R34 per share. We believe that this offer will be successful and that we'll realise a fair price for our investors.
At the end of 2014 we took part in a discounted rights issue in Immobiliare Grande Distribuzione (IGD) an Italian Real Estate Investment Trust. The proceeds of the rights issue were used to recapitalise their indebted balance sheet. IGD had attracted our attention towards the end of 2012 when it was trading at half of its book value. IGD had been caught up in the dislike for Southern European markets at that time. IGD's share price rerated once some of the fear around the macro issues in the region had dissipated and RECM was able to take some client capital off the table. Mr Market turned gloomy again as IGD announced a rights issue at the end of 2014 at a 60% discount to net asset value in order to reduce the gearing in the business. We followed the rights on behalf of our clients and increased the amount of capital allocated to the business at a fair discount to the intrinsic value post the rights issue. Subsequently, IGD's rating has improved on the back of a stronger balance sheet and RECM has been a seller of IGD shares at a handsome profit to our all-in price.
The correct action with a rights issue depends on the price relative to intrinsic value
Investing is a discipline that deals with future events, which are by their nature uncertain. Ensuring that the margin of safety with which capital is allocated to investment ideas is maintained in a disciplined manner reduces the risk of permanent capital loss and protects investors against unforeseen events. At RECM we consider rights issues with this same discipline.